Where to put money with Europe on the mend

Economic ‘green shoots,’ undervalued shares attract bold buyers

SAN FRANCISCO (MarketWatch) — The euro-zone economy, while clearly not good, is arguably less bad nowadays. And with European stocks currently priced cheaper than both U.S. and Japan equities, many global market strategists are recommending that investment portfolios sport a little continental style.

Investors were further encouraged last week when the euro zone’s manufacturing sector reported growth for July — the strongest report in two years and suggestive of continued growth in the third quarter. Many observers are also optimistic that German parliamentary elections in September will be a turning point where Europe moves away from fiscal austerity and towards more accommodative, growth-oriented policies, perhaps including interest-rate cuts.

Why do investors take risks?

“We do like the European economy,” said Audrey Kaplan, head of international equities at Federated Investors and manager of Federated InterContinental Fund
RIMAX, -0.02%
Regarding European stocks’ valuation, Kaplan added: “The U.S. market has run up quickly and may take a breather, so there will be a lot of people looking around for opportunities.” Read more: The case to go long Europe.

Analysts at Bank of America Merrill Lynch offer a strong sense of the shifting mood. A mid-July research report highlighted seven reasons to consider European stocks, including: the euro zone emerging from recession by year-end; less fiscal austerity, which should aid growth; diminished chance of a “black swan” event that tips the region into crisis; recovering European corporate earnings, “incredibly attractive” market valuations; widespread skepticism about the euro zone, and historical evidence that euro-zone stocks outperform when U.S. bond yields rise.

Europe's week ahead

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Chinese data is expected to dominate sentiment next week as markets continue to debate Fed tapering. The Bank of England’s Inflation Report and meetings by the Reserve Bank of Australia and the Bank of Japan will also add to the mix.

Emblematic of the early stages of a recovery and the prospect of lower interest rates, investors are especially optimistic about the European banking sector.

“European bank prices relative to U.S. banks are close to an all-time low,” Kaplan said. “European banks are at a level where they may outperform their U.S. counterparts. The financials right now are fundamentally inexpensive. You want to invest in companies when they’re out of favor.”

Outside of the banking sector, German auto maker Daimler AG
DAI, +0.55%
is a top holding in the Federated InterContinental portfolio. “It’s a luxury-goods company, a premier trucks company, and a play on Asia,” Kaplan said. The fund manager also likes Siemens AG
US:SISIE, +0.57%
largely due to the industrial giant’s stock trading at what Kaplan estimates is a 25% discount to shares of rivals General Electric
GE, +0.79%
and Philips
PHG, +0.37%PHIA, +0.09%

Not over, over there

Yet investing in Europe is a tightrope walk, and even cautious optimism is just an unwelcome headline away from turning negative. Some strategists contend that the advances of the past few weeks mask endemic problems, including double-digit unemployment and anemic bank lending.

“Conditions have stopped worsening, and Europe’s economy may be stabilizing after a period of rapid economic deterioration. However, the deep-rooted negatives that lie not far under the surface may disappoint those expecting steady improvement, much less a powerful rebound,” noted Jeffrey Kleintop, chief market strategist at LPL Financial.

“While there is no longer any reason for dire predictions about Europe’s economic future, neither is there reason for much optimism,” Kleintop added. “Most countries in Europe will remain economically fragile, and flat-to-weak economic growth is likely to be the prominent trend.”

Some strategists are bullish on Britain as a way to gain European market exposure without messy euro-zone politics.

The U.K. is part of the European Union but isn’t tied to the troublesome euro
EURUSD, -0.5086%
an autonomy that led Cam Hui, a portfolio manager at Qwest Investment Fund Management, to raise the British flag on his “Humble Student of the Markets” blog in a post last month.

Both of these funds have been moving higher lately, but the U.K. market offers stability that’s been in short supply in the region, Hui said, and is “a way to get exposure to the euro-zone economies without the drama.”

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